Be Defensive: Use Stop Orders

Managing Director of Trading and Derivatives, Schwab Center for Financial Research

- April 11, 2014

Key Points

Stop orders may help you obtain a predetermined entry or exit price, limit a loss or lock in a profit.

There are three main types of stop orders: standard stop orders, stop-limit orders and trailing-stop orders.

Find out how to gauge stock volatility when you set your stop orders.

Stop orders are most often used to help protect an unrealized gain or to limit potential losses on an existing position. Here, we'll discuss how to use them in your portfolio to protect long equity positions.

What is a stop order?

Stop orders come in three main varieties: standard stop orders, stop-limit orders and trailing stop orders. Stop and stop-limit orders are entered and held in the marketplace, while trailing stop orders are held on a Schwab server until conditions you define are met or exceeded, followed by the routing of an order for possible execution.

To better understand how stop orders work, it's helpful to think of the stop price as a trigger. For example, once an execution occurs at your designated trigger price, your stop order becomes a market order to buy or sell that stock at the prevailing market price. Note that stop orders are inactive and hidden to the other market participants until the trigger price is reached.

The table below compares the three stop-order categories.

Three types of stop orders

Source: Schwab Center for Financial Research.

Stop orders (also known as stop-loss orders) and stop-limit orders are very similar, the primary difference being what happens once the stop price is triggered. A standard sell-stop order is triggered when an execution occurs at or below the stop price. When this occurs, a market order to sell is sent to the marketplace and your position will be closed out at the next available price.

Example: If the current price of a stock is $90 and you want to protect against a significant decline, you could enter a sell-stop order at $85. If an execution occurs at $85 or lower (at the same venue where your order resides), your stop order is triggered and a market order is entered to sell at the next available market price. Because the stop order is now a market order, all characteristics of market orders apply.

In most cases, your stock will be sold at a price that is close to the market price at the time the stop order is triggered. However, you must remember that a stop order becomes a market order, so in cases where the stock is halted and reopens for trading or when the stock gaps down in the morning (lower than the prior day's closing price), your execution price could be significantly lower than your stop price.

Stop-limit orders are most often used to sell a security at a specified limit price once the security has traded at or through a specified stop price. Therefore, it has two components: the stop price and the limit price, which may or may not be the same.

Unlike standard stop orders, with a stop-limit order, you must enter both a stop price and a limit price. In most cases, the limit price on a sell stop-limit order will be equal to or below the stop price. As the stock begins to decline in value, if the stock trades at or below the stop price, the order will trigger and become a limit order to sell at the specified limit price.

Because the order is now a limit order, execution cannot occur unless the position can be sold at the limit price specified (or better). If the next available price after the stop price is reached is below your limit price, your order will not be executed unless the price increases back up to your limit price. All other characteristics of limit orders apply as well.

To increase your chances of execution on a stop-limit order to sell, consider placing your limit price below your stop price. The further below the stop price you place your limit price, the better chance you have of executing your order in a rapidly declining market.

With any type of limit order, including stop-limit orders, you aren't guaranteed execution because the stock may trade below the limit price before the order can be filled. This often occurs when a stock is reopened for trading after being halted due to a significant news announcement, or when the stock opens for trading in the morning at a price that is much lower than the previous day's closing price. When this occurs, a stop-limit order may trigger and be entered in the marketplace as a limit order, but the limit price may not be reached.

Example: The current price of a stock is $90. You place a stop-limit order to sell 100 shares with a stop price of $87.50 and a limit price of $87.50. If an execution occurs at $87.50 or below, your order will be triggered and become a limit order to sell at $87.50 or higher. If the market is falling fast, your order may not be filled at all if the next trade occurred at $87.45 and the stock continued to decline. However, if you entered your order with a stop price of $87.50 and a limit price of $87 and the next trade after the $87.50 trigger was at any price above $87, your order would typically be executed.

Keep in mind, your order can't be executed at a price that is inferior to the best available price, even if your limit allows for it. Therefore, in a slowly declining market, your order might be filled at $87.50 or better if market conditions allow for it.

With a trailing-stop order, the stop price trails the price of the stock as it moves higher. The stop price essentially self-adjusts and remains below the market price by the number of points or the percentage that you specify, as long as the stock is moving higher. Once the stock begins to move lower, the stop price freezes at the highest level it reaches.

In other words, the stop price can move higher indefinitely, but it can never move lower. If the stock falls enough to reach the stop price, the order is triggered and sent to the marketplace. The primary benefit of a trailing-stop order versus a regular stop order is that it doesn't have to be canceled and re-entered as the price of the stock increases. As mentioned above, this order is held on a Schwab server until the stop price (trigger) is reached.

Example: Assume you placed a 5% trailing stop order on a recently purchased stock position. As the stock increases in price, if at any point the bid retraces (falls) by 5%, a market order will automatically be entered for the quantity you specified. For example, if you entered this order when the stock price was $100 per share, if the bid price increases 9% to 109 (assuming it never pulled back 5% on its way up to 109) and then drops 5% to 103.55, the order will be sent. The effective change from the time the trailing stop was placed until the order was triggered would be 3.55% above where you originally placed the order. Since a trailing stop order becomes a market order when triggered, it behaves very similar to a standard stop order.

Trailing-Stop Order

Source: StreetSmart Edge®.

Where should you set your stop order?

When you place a stop, stop-limit or trailing stop order, you have to decide how many points or what percentage below the stock price to place the order.

Many traders have a standard policy that they use, such as 5% or 10% below. For traders who determine the size of each trade based on the dollar amount invested, rather than the share quantity, a point value may be more effective than a percentage.

Some disciplined active traders follow a rule that no loss should exceed a certain percentage of the value of their total portfolio. For example, some traders might set this percentage at 1% to 3% of the value of their portfolio or whatever percentage they feel may appropriate. In addition, if you've had a recent string of losses, you may want to consider keeping your stops a little closer until your success rate picks up.

Regardless of what methodology you use, be careful not to place the stop price too close to the current price or the order might be triggered by regular daily price fluctuations. Similarly, you don't want to place the stop price too far from the current price or you may sustain a sizable loss before you exit the position.

One way to reduce the likelihood of either of these things occurring is to pay attention to the volatility of the stock. Clearly, if you're trading a highly volatile stock that has a history of fluctuating as much as 5% in price daily, placing a stop order 5% below your entry price is likely to result in an unfavorable outcome. If you're unwilling to assume the risk of daily fluctuations of 5%, then consider not trading that particular stock. By contrast, a 5% stop order may be appropriate for a stock that has a history of 5% fluctuations in a month.

Using a few days of pricing data, you can calculate the average daily price change for a stock. The table below lists the hypothetical daily closing prices for XYZ over six consecutive trading days. As you can see, the average day-to-day closing price change for the week has been only $0.45, or about 0.82%. For the full week, the net change was only $0.28, or about 0.51%. Entering a 5%, or a three-point, stop order on XYZ would likely provide adequate protection and reduce the risk of being stopped out too soon.

Hypothetical daily closing prices for XYZ stock

Source: Schwab Center for Financial Research.

Additionally, Schwab's StreetSmart Edge trading platform has a historical volatility chart study that makes it relatively easy to gauge the recent volatility of any stock. While the historical volatility calculation is a little more complex than the daily change calculation, it's relatively easy to tell whether a stock is highly volatile or not. In the first example below, the 30-day historical volatility (blue line) of hypothetical XYZ has been 21.82%. In the second example below, hypothetical ZYX has had a historical volatility of 68.83% during the same period of time. Clearly, if you have the risk tolerance to trade ZYX you would want to allow more room for your stop order, whether you are setting it based on points or percentage.

Stop Orders and Historic Volatility: First Example

Source: StreetSmart Edge.

Stop Orders and Historic Volatility: Second Example

Source: StreetSmart Edge.

Being defensive

The main message you should get from the stop order types discussed here is that there's a number of alternatives available to you to protect your positions. Whether the markets are in a period of high or low volatility, traders should consider including the use of these tools.

I hope this enhanced your understanding of trading. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.

Next Steps

• Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
• Not yet a client?Learn more about Schwab Trading Services.

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Important Disclosures

The trailing stop feature should not be confused with the stop order (order type). All StreetSmart Edge alerts with trailing stops or other conditional orders will be entered as a market or limit order types (same day only).

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